Overview: In a defined contribution plan, the contribution is specified — not the benefit. The employee bears investment risk, but also owns an individual account that can grow substantially over time.

The fundamental shift from a defined benefit to a defined contribution (DC) plan transfers investment risk from employer to employee. The employer commits to putting a certain amount into the employee's individual account; what that account is worth at retirement depends on contributions made and investment returns earned. There is no PBGC insurance for DC plans.

Money Purchase, Profit-Sharing, and Stock Bonus Plans

These three plan types are all defined contribution plans, but they differ in how contributions work.

A money purchase plan requires the employer to contribute a fixed, mandatory percentage of each employee's compensation every year — for example, 10% of salary. This obligation exists regardless of whether the business was profitable. Failure to fund the required contribution triggers IRS excise taxes. The contribution rate cannot simply be changed year to year; the plan document must be formally amended.

A profit-sharing plan gives the employer maximum flexibility. The employer decides each year whether to contribute and how much, up to a ceiling of 25% of covered compensation per participant. In lean years, the employer can contribute zero (though the IRS requires contributions to be "substantial and recurring" over time to maintain qualified status). This flexibility makes profit-sharing plans popular with businesses that have unpredictable revenue.

A stock bonus plan functions similarly to a profit-sharing plan but contributions are made in the form of employer stock rather than cash. Distributions are typically made in company stock. The annual contribution is discretionary, and like profit-sharing plans, stock bonus plans are not subject to the IRS minimum funding standards that apply to money purchase plans.

The 2024 combined contribution limit for all these plan types (as well as 401(k)s) is the lesser of 100% of compensation or $69,000 from all sources (employee + employer). This is the Section 415 limit.

Employee Stock Ownership Plans (ESOPs)

An ESOP is a special type of defined contribution plan that is designed primarily to invest in employer stock. It serves a dual purpose: it is a qualified retirement plan for employees and a vehicle for employee ownership of the company.

Unlike a 401(k), employees do not contribute to an ESOP out of their own paychecks. The company funds the ESOP by contributing cash to purchase stock, contributing stock directly, or — most commonly — by borrowing money to buy a large block of stock at once (a leveraged ESOP). In a leveraged ESOP, the loan is repaid with annual tax-deductible company contributions, and shares are "released" from a suspense account into employees' individual accounts as the loan is paid down.

Shares allocated to employees vest over time (typically three to six years) and are distributed when the employee retires or leaves. Because the company's stock may not be publicly traded, ERISA requires the company to purchase shares back from departing employees at fair market value — a put option the company must honor. This "repurchase liability" can be significant if many employees retire at the same time.

The tax advantages of ESOPs are remarkable. A C-corporation owner who sells at least 30% of the company to an ESOP can defer capital gains taxes by reinvesting proceeds in qualifying replacement securities (IRC Section 1042). If an S-corporation is 100% owned by an ESOP, the company pays no federal income tax because the ESOP trust is a tax-exempt entity. And company contributions used to repay both principal and interest on the ESOP loan are tax-deductible.

A key risk for participants is lack of diversification — their retirement savings and their job are both tied to the same company. ERISA addresses this by requiring plans to offer diversification options to participants who are age 55 or older with at least 10 years of participation.

Salary Reduction Plans: 401(k), 403(b), and 457

Overview: Salary reduction plans allow employees to contribute a portion of their pre-tax (or Roth after-tax) pay into a retirement account, often with an employer match — making them the most commonly encountered retirement plans in American workplaces.

401(k) Plans

A 401(k) is the most common employer-sponsored retirement plan in the private sector. Employees elect to defer a portion of each paycheck — pre-tax under the traditional option or after-tax under the Roth option — into an individual account. The employer typically offers a menu of investment choices, and many provide a matching contribution to incentivize participation.

For 2024, the employee elective deferral limit is $23,000. Employees age 50 or older can contribute an additional $7,500 as a catch-up contribution, bringing their total to $30,500. The combined employee-plus-employer limit under Section 415 is $69,000. (Note: Exam questions may use the 2024 figures, which are the most recently finalized limits; the IRS adjusts these annually for inflation.)

With a traditional 401(k), contributions are made pre-tax, reducing the employee's current taxable income. Growth is tax-deferred, and all distributions in retirement are taxed as ordinary income. With a Roth 401(k), contributions are made after-tax with no current deduction, but qualified withdrawals — including all investment gains — are completely tax-free, provided the account has been open at least five years and the participant is at least age 59½. Unlike Roth IRAs, Roth 401(k) balances (prior to SECURE Act 2.0) were subject to required minimum distributions, but SECURE 2.0 eliminated lifetime RMDs for Roth 401(k) accounts, aligning them with Roth IRA rules.

Distributions before age 59½ generally incur the 10% early withdrawal penalty plus ordinary income tax, with exceptions for certain hardships, disability, and other circumstances detailed later in this chapter.

403(b) Plans

A 403(b) plan — also called a Tax-Sheltered Annuity (TSA) — is structurally similar to a 401(k) but is available only to employees of public schools, 501(c)(3) nonprofit organizations, cooperative hospital service organizations, and self-employed ministers.

The standard contribution limits mirror those of 401(k) plans ($23,000 in 2024, plus $7,500 catch-up for age 50+). The critical eligibility difference is the Universal Availability Rule: if an employer allows any employee to make elective deferrals, it must allow all employees to do so (with minor exceptions for students and employees working fewer than 20 hours per week). This is broader than the 401(k) standard, which can impose age-21 and one-year-of-service waiting periods.

The unique 403(b) feature is the 15-year service catch-up: employees with 15 or more years of service with the same eligible employer can contribute an additional $3,000 per year, subject to a $15,000 lifetime cap. This catch-up is based on tenure rather than age and is available even to employees under 50 — it cannot be used by 401(k) participants.

457 Plans

A Section 457 plan is a deferred compensation arrangement available to employees of state and local governments and certain nonprofits. Governmental 457(b) plans function much like 401(k)s — contributions reduce taxable income, assets are held in trust, and participants can invest in a menu of options. The 2024 contribution limit is $23,000 (same as 401(k)), with a $7,500 age-50 catch-up.

Two features make 457 plans distinctive. First, governmental 457(b) plans have no 10% early withdrawal penalty upon separation from service regardless of age — participants can access funds after leaving their employer without penalty, unlike 401(k) or 403(b) plans. Second, if an employer offers both a 457(b) and a 403(b) or 401(k), an employee can contribute the full limit to both plans simultaneously — potentially sheltering $46,000 in a single year.

Non-governmental 457(b) plans offered by nonprofits are more restricted: they are top-hat arrangements open only to highly compensated employees and management, and plan assets remain the employer's property (not held in trust), exposing participants to creditor risk.

FAQ

What is the difference between the $23,000 deferral limit and the $69,000 Section 415 limit?
The $23,000 (2024) limit caps what the employee can contribute through elective deferrals. The $69,000 Section 415 limit caps the total of all contributions from all sources — employee deferrals plus employer matching and profit-sharing contributions. If your employer contributes $15,000 as a match, you can still defer the full $23,000, because $23,000 + $15,000 = $38,000, well under $69,000.

Can an employee in a 403(b) use both the 15-year catch-up and the age-50 catch-up?
Both catch-ups can potentially be available simultaneously, but complex IRS ordering rules apply. The 15-year catch-up is used first, up to the lesser of the additional $3,000 or the plan's available limit. The age-50 catch-up applies to any remaining capacity. Most exam questions treat them as separate and additive; consult IRS Publication 571 for the precise calculation.

Do 457(b) plans require ERISA compliance?
Governmental 457(b) plans are not subject to ERISA because they are government plans. Non-governmental 457(b) plans are also largely exempt from ERISA as top-hat plans, though they must comply with IRC Section 409A.